Dodd-Frank and SEC blaze new trail for credit ratings

NEW YORK, April 19 (Westlaw Business) – Dodd-Frank’s credit-rating provisions do more than just hamstring ratings agencies; they also open new frontiers of opportunity.

Already on the wane as a result of their collective role in the world financial crisis, the influence of the big ratings agencies will soon take another hit as the Dodd-Frank financial regulation overhaul formally strips these analysts of their aura of omniscience. Obscured in the conversation is what collateral effects may spring from this new regulation.

A rule proposed recently by the SEC will, as directed by Dodd-Frank, officially remove the sanctifying effect of determinations by credit raters regarded as nationally recognized statistical rating organizations (NRSROs) in four rules under the Investment Company Act of 1940.

Rules 2a-7, 3a-7, 5b-3 and 10f-3 will no longer require money-market funds to operate using NRSRO ratings; rather, the new rules attempt to craft an alternative to a regulatory scheme seasoned by familiarity and, in hindsight, considerable flaws.

NO MORE ONE-SIZE-FITS-ALL

The new rules reject the objective, one-size-fits-all ratings reliance. In its stead, the SEC will opt for a “subjective” standard the Commission hopes will replicate existing safeguards without the drawbacks of an NRSRO carte blanche. With respect to rule 2a-7, a money market fund will still be required to determine whether a security is “eligible,” as well as whether an eligible security merits “first tier” or “second tier” designation. The wrinkle is that where this analysis formerly rested upon a rating by an NRSRO, the fund’s boards of directors must now make their own independent evaluations.

The SEC expects this alternative structure to capture credit risk competently. A fund’s board of directors must determine that a security’s issuer (or guarantor, if applicable) has the “highest capacity to meet its short-term financial obligations.”

Beyond this nebulous benchmark, the board can designate a security as eligible only if it “determines that [the security] presents minimal credit risk…based on factors pertaining to credit quality and the issuer’s ability to meet its short-term financial obligations.”

For a first-tier security, the standard requires “an exceptionally strong ability to repay its short-term debt obligations and the lowest expectation of default.” The second-tier security, which the amended rule still limits to three percent of total fund assets, must “have a very strong ability to repay its short-term debt obligations, and a very low vulnerability to default.”

Other existing rules impacted by the proposed rule have equally amorphous subjective standards. Rule 5b-3, for example, affects repurchase agreements for securities and their attendant collateralization.

The proposed rule does away with the reliance on NRSRO ratings, proposing instead to require that collateral other than cash or government securities consist of securities that the fund’s board of directors (or its delegate) determines at the time the repurchase agreement is entered into are: (i) issued by an issuer that has the highest capacity to meet its financial obligations; and (ii) sufficiently liquid that they can be sold at approximately their carrying value in the ordinary course of business within seven calendar days. (emphasis added)

RISK-ASSESSMENT TOOLS

Significantly, none of the existing rules affected by the proposal prevents a fund’s board of directors from using NRSRO ratings as part of its analysis. Such use, however, would now be as one of several tools employed in a discrete examination, rather than a statutory shield behind which a fund could hide were things to go south.

Indeed, one aspect of the proposed rule — affecting Forms N-1A, N-2 and N-3 — still requires that, to the extent a mutual fund employs an NRSRO rating, the fund must limit itself to a single ratings agency for all securities. Ratings shopping remains out-of-bounds.

Profound may be too strong a word to describe the new proposed rule’s changes, but the consequences may be more broad than first anticipated.

Foremost among these changes will be a new landscape for credit and other securities analysis. The oligarchic stranglehold on the business by the big players — Moody’s, Standard & Poor’s and Fitch — has been loosened. These NRSROs will still continue to play a role; the new rule does not prohibit their use, it simply no longer requires it as a matter of law. What the new rule should do, however, is open the door to a new nimble, entrepreneurial class of analysts that can provide a comparable service at competitive cost.

Although the proposed rule requires the funds’ boards to make subjective determinations of credit worthiness of invested securities, the rule lays down no hard and fast means for doing so. As Congress could not have intended for boards to inspect these securities books literally, the rule presupposes some kind of outside assistance.

“Fund boards of directors (which typically rely on the fund’s adviser) would still be able to consider quality determinations prepared by outside sources, including NRSRO ratings, that fund advisers conclude are credible and reliable, in making credit risk determinations,” explained the SEC. “We would expect the fund advisers to understand the method for determining the rating and make an independent judgment of credit risks, and to consider an outside source’s record with respect to evaluating the types of securities in which the fund invests.”

This creates a dynamic opportunity for a new class of credit experts to work their way into the fabric of securities analysis. The funds that hire these analysts will have to show their reliance on these experts was credible. What they won’t have to show is reliance on one of the Big Three. Assuming these boards of directors create paper trails documenting their reliance, they can satisfy the new rule.

But this modified reliance raises a significant issue of its own. Formerly, the NRSRO rating gave at least a baseline for investment decisions by funds. The new regime takes a big step in shifting the burden of responsibility. If determinations as to a security’s creditworthiness are truly material, does a fumble by the fund’s board of directors create liability?

If an investment turns sour, can subjective decisions now be collaterally attacked? If so, by whom? Will a faulty decision-making process give way to a private right of action by disgruntled investors? To what degree will the SEC now scrutinize these decisions? Will every investment decision be pored over, or only those that lead to losses? Finally, what does this burden-shifting mean for the business judgment rule?

The remarkably fluid standards within the proposed rule could either insulate or penalize a fund’s board of directors. If the provider of an ad hoc analysis of a security issuer has been thoroughly vetted, presumably, a fund’s board shouldn’t be liable for errors within the analyst’s report. On the other hand, one can also imagine a Wild West scenario in which wagonloads of self-proclaimed credit-rating analysts hang out their shingles, professing expertise in this arena. Of course, even the most dubious claims will be hard pressed to match the track record of the NRSROs in the recent credit default swaps/collateralized debt obligations fiasco.

The SEC cites the Investment Company Institute for its projection that 652 funds will be affected by the proposed rule. This figure may not set off a gold rush, but when combined with other Dodd-Frank diminutions, it could be enough to see a blossoming of a new cottage industry. Whether a new credit crisis can be averted remains to be seen; in any event, Dodd-Frank means a new frontier for credit ratings.

(This article was first published by ThomsonReuters’ Westlaw Business Currents, a leading provider of legal analysis and news on governance, transactions and legal risk. Visit Westlaw Business Currents online at http://currents.westlawbusiness.com).

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